When I say averages, I am definitely
NOT referring to Dollar Cost Averaging (DCA). In Discussion 1, I have clearly indicated the shortages and irrationality of using DCA.
However, I strongly encourage my readers to add Moving Averages (MA) to their charts. In my opinion, MA is an invaluable indicator that should be utilized together with most indicators available in Technical Analysis (TA).
So what MA actually is?
MA is the
running average price of a stock over a period of time.
CALCULATION OF MOVING AVERAGE
For instance, we have a set of stock prices ranging over a period of 5 days as such:
Day 01 = RM1.60
Day 02 = RM1.20
Day 03 = RM1.40
Day 04 = RM1.30
Day 05 = RM1.50
On Day 5, the 5 day MA for the stock prices would be
MA5d = {RM1.60 + RM1.20 + RM1.40 + RM1.30 + RM1.50} / 5 days
= RM1.40
Come Day 6, the stock price dropped to RM1.45. The 5 day MA for Day 6 would be
MA5d = RM1.40 + {RM1.45 (Day 6) - RM1.60 (Day 1)} / 5 days
= RM1.37
Always take note that in calculating MA, the old data (Day 1) would be discounted to make place for the new data (Day 6), forming the "running" or "moving" nature of the average. That's why it is called "Moving Average"!
The MA line would then be plotted on your chart.
WHY USE MOVING AVERAGE?
In stock trading, it is always important to know that even when the candlesticks show that the stock price is currently in an uptrend, it is equally significant to also monitor its MA.
MAs that are usually used in stocktrading is MA14d, MA20d, MA26d, MA50d, MA70d, MA100d and MA200d. Personally, I have a tendency of using
MA20d, MA50d, MA100d and
MA200d.
There are three main usages of MA:
1) To
smoothen out variations and clearly presents the
price trend over a period of time.
2) Time entry and exit via
Bullish Crossover and
Bearish Crossover.
3) Acts as
Support and Resistance in a price trend.
SMOOTHENS OUT VARIATIONS AND CLEARLY PRESENTS THE PRICE TREND
Sometimes people ask me, "Why does a stock price sometimes moves up and sometimes moves down?"
That is a very simple, yet good question. If you could understand the principle behind price movements, then you will not experience devastating heartbeats when prices move against your wish! :-)
In investing, as well as business, we know that the selling price of inventories (stocks) is mainly driven by the public's
supply and demand. In stock trading, shares are viewed as our inventories (as in business), and the stock price (selling price) is similarly driven by the market's supply and demand.
Ali is a fast food chain business owner specializing in serving poultries. He would be experiencing great sales and profits during calendar events such as Christmas, when demand for turkey rose. He would sell the turkey at a high. During news outbreak of 'bird flu', he would be forced to sell at a low, even when he had bought the birds at high.
Same goes to stocks. How often do you see stock prices change drastically during these events? Very often. Just look at the recent rumoured election and its impact on the FBMKLCI. However, all these changes are only temporary. Ali would have his sales recovered after a year of bird flu, or maybe his sales price would drop back to normal a week after Christmas.
These sudden surge or decline in prices are what statisticians normally term as
Seasonal Variation (SV). When we look at the candlesticks, it clearly shows a sudden price break-out, but in fact, it is due to events such as the company won a favourable contract overseas.
At this moment, speculators would come in and push the stock price to a great high, sometimes even ridiculously high. Uninformed investors would then think that the prices are going up, so they re-mortgage their houses, sell their cars, and bought this stock at a high.
Next day, after the analysts are done calculating the company's new net worth, the speculators start to sell all these stocks, causing the prices to go down during the next few weeks. Later, you would be able to see a lot of bankruptcies in the newspapers.
To make the matter worse, the price trend thereon looks uncertain. Is it now going up or going down? Should I be trading in this stock now?
Therefore, statisticians develop MA to
smoothen out these SVs. MA takes an average over a period of time, so that these sudden price surges do not manipulate the trend by much. See illustration (i) and (ii). It shows the share prices of TIME during and after the abnormal price outbreak on 12 November 2010.
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| Illustration (i) : TIME Surge |
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| Illustration (ii) : TIME Decline |
In illustration (i), we can see that prices for TIME dotCom went on an unusual high (RM0.57) on 12/11. In illustration (ii), the price drops in the next few days to RM0.39, a decline of 31.6%. Despite these unusual movements on 12/11, the MA20d did not sway much. The trend still shows that TIME dotCom is chopping its way to the sides.
Traders could then base on this MA20d to make their decisions on whether to trade or not to trade in this stock. In my opinion, I would not trade a stock until it is trending upwards.
(Note: In illustration (ii), I would be rather careful on 12/11 to decide whether to enter into TIME or otherwise. Have a look at the "Dark Cloud Cover" formed on 11/11, which gives a Bearish Reversal signal. Due to the prior trend not being an uptrend, I would wait for another day to see how the candlesticks, and other indicators look like. I'd rather fold a deal than to expose myself to an unmanaged risk!)
MOVING AVERAGE BULLISH AND BEARISH CROSSOVERS
In charting, I would be using more than one MAs most of the time. As indicated earlier, I use 4 MAs - MA20d, MA50d, MA100d and MA200d.
The shorter the MA period, the faster the MA is, and vice versa.
This is because the shorter the period is, the faster the new data would play an impact on the MA line. Therefore, it can be said that MA20d is faster than MA50d, and MA200d is slower than MA100d.
Buy and sell signals are generated when the MA lines of different speed crosses over one another.
When a faster MA crosses over a slower MA from the
bottom, a
buy signal is generated.
When a faster MA crosses over a slower MA from the
top, a
sell signal is generated.
The former is termed
Moving Average Bullish Crossover.
The latter is termed
Moving Average Bearish Crossover.
Look at the chart now.
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| Illustration (iii) : MA Bearish Crossover |
Illustration (iii) shows a snapshot of the prices during late 2007 and early 2008 of GENTING. Notice that all four points show a faster MA crosses over a slower MA from the top. These are all known as MA Bearish Crossover, which in turn, means a signal to
sell.
Out of those four crossovers, the one that involved MA20d crosses over the MA100d gave the most dangerous signal to sell. This crossover means, "For the past 20 days, the average stock price has performed below the average of past 100 days".
The MA100d here is more important compared to the MA200d as the MA100d being the lowest (last line of defense) for the stock price. Therefore, generally speaking, the price has been moving lower and lower, and could potentially head into an imminent downtrend.
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| Illustration (iv) : Downtrend after Crossover |
Illustration (iv) shows what happened after the series of crossovers. The price trended downwards until early 2009.
Sometime during August, the stock price rebounded upwards for a moment, creating a Bullish Crossover. Subsequently, it created another Bearish Crossover in September. This is what we termed as
False Signal.
False Signal will inevitably emerge in almost, if not all Technical Indicators at some point of time. This is the reason why most technicians will not rely only on a single indicator to base their decisions on. TA indicators should complement each other to bring out their full potential as a whole.
Always remember that by using TA, you are not sure to make money. You are only maximizing your probability of making money. Always be disciplined to cut losses when things don't go your way. I always believe in a saying, "If you have to gamble anyway, then gamble rationally, never emotionally". Do not hope that you will win a losing trade by holding onto it. You are destroying your portfolio!
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| Illustration (v) : MA Bullish Crossover |
For the rest of the year 2009 until early 2010, GENTING rebounded and trended upwards. In illustration (v), you can see that there are 6 Bullish Crossover points supporting the uptrend.
In fact, when the Bullish Crossover of MA20d over MA50d was formed, a
buy signal was triggered. It was then further confirmed when MA20d crossed over MA100d, and subsequently MA200d.
Again, a False Signal was generated during November and December 2009, and then subsequently a Bearish Crossover in February 2010 signalled the end of the uptrend. The price then dropped to slide on a down.
Some investors/traders make use of what they called
Triple Moving Average strategy in analyzing their trades. In this strategy, they will plot three MAs on their chart - A fast MA, a second fast MA and a slow MA. For instance, they might use MA20d, MA50d and MA100d.
When MA20d crosses over MA50d, they will buy 1/3 of their intended trading size for that stock. When MA20d crosses over MA100d, they will buy another 1/3, and finally when MA50d crosses over MA100d, they will buy the final 1/3 to complete the portfolio. The reverse is also applicable for a bearish crossover.
However, I personally would not have used such trading strategy. It doesn't seem to make much sense to me. If you understand the limitations of MA, which I would share at the end of this Discussion, then you might not even consider this as a strategy.
MOVING AVERAGE AS SUPPORT / RESISTANCE
MAs are very useful rulers to rely on, as proven over and over again in Technical Charts, to determine support and resistance of a price trend.
Let us look at GENTING again.
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| Illustration (vi) : MA as Resistance |
MA act as a strong resistance during a downtrend. Its characteristics of support and resistance are almost similar to the concept we have discussed in Discussion 4 (Part 2). When a stock price made a pull back during a downtrend, it would find its resistance and then continue its fall thereafter.
In a downtrend, the support can easily be found by drawing a straight line connecting a few lower lows. You can then almost gauge where the next low is. Refer illustration (vi) for a better understanding. It is the same chart that you see in illustration (iv).
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| Illustration (vii) : MA as Support |
Illustration (vii) shows how MA acted as a comfortable support in an uptrend. When a stock retraces from an uptrend, it will seek its support before bouncing off to continue its climb. Again, you can easily gauge the next resistance in an uptrend by drawing a straight line that connects a few higher highs.
When a stock price lingers around a support or resistance, traders/investors should start to pay attention to the next movements of that stock. Should the price breaks the support or resistance, then the stock price would most probably seek its way to the next support or resistance. Otherwise, it would just rebound off the support or resistance and continue its trend.
This should help to generate the right buy or sell signal.
LIMITATIONS OF MOVING AVERAGE IN STOCK ANALYSIS
First of all, users of MAs must know the nature of the tool that they are using. MAs are most of the time categorized as a
trend follower. A trend follower often
lags behind the actual trend. The nature of it averaging the prices over a period of time would usually dilute the sensitivity of the newest stock prices. Sensibly speaking, the newest prices should spearhead the direction of a trend.
Therefore, there are many efforts taken to improve on the MAs to introduce higher weightings on the most recent prices. Such efforts gave birth to variations such as
Weighted Moving Average (WMA) and
Exponential Moving Averages (EMA). The MAs elaborated since the beginning of this Discussion are also sometimes known as
Simple Moving Average (SMA).
The SMA and WMA are
finite impulse response filter, while EMA in nature, is an
infinite impulse response filter. SMA and WMA discounts old prices using a solid and absolute factor, while EMA discounts old prices using a factor which intends to reduce the previous day's EMA over an infinite period of time, which its value will never be reduced to zero.
By far, the most popular MAs that are used in stock analysis are SMA and EMA. EMA definitely addresses the lagging shortage of SMA. However, using EMA, there are higher chances of it giving False Signals. In a sudden price surge or decline, the EMA will show a drastic change in the EMA line, thereby,
1) Distorting the actual trend of the stock price.
2) The drastic change might cross the faster EMA with a slower EMA, or vice versa, thereby creating a False Signal.
Using SMA, on the other hand, would also generate a
lagging buying or selling signal during a crossover. In illustrations (iv) and (v), sell and buy signals are generated only
AFTER the price begin to drop or rise. In that case, more losses are absorbed, and less profits are taken, due to the late entry and exit signalled by the SMA.
Therefore, if you are trading based on SMA, you can then forget about the Triple Moving Average strategy. You can dream about buying at the lowest and selling at the highest using that strategy. It won't happen. It will never happen because SMA lags.
One more thing about SMAs is that they should only be relied on in a
trending stock price, such as an
uptrend, or
downtrend. When the stock price moves sideways (sometimes it is called
consolidation or in the United States, it is more commonly referred to as
Channel Market), due to the lagging nature of the SMAs, they will give out plenty of False Signals.
Relying on them to make a decision in a Channel Market is extremely risky and in most of the times, even if it turns out fine, it won't give investors/traders good returns.
WHICH MOVING AVERAGES SHOULD I USE?
Depends on you. Usually, I take MA20d as my favourite MA line. It is due to the belief that I am willing to hold this share out for 20 days before I liquidate my position. Sometimes, when the price doesn't turn out, and it doesn't fall below the support I've set to cut loss, I will hold it for a maximum of 20 days. If it still doesn't turn out the way I wanted it to be, I'll proceed with liquidating my position (be it a loss or gain).
Some long term investors would find MA200d or MA250d more useful. It means, any price fluctuations above this MA line would not trouble the investors at all, because they are holding the position for long term. As long as the price does not fall below the MA line, it means the stock is still uptrending.
Some day traders and swing traders would like a shorter MA, such as MA5d, MA10d, or MA14d. Recent prices are more useful to them compared to historical prices. Therefore, it is all down to your trading/investment preferences. :-)
CONCLUSION
In many situations, MAs have helped me to determine the trend of a stock price, as well as clearly pointing its related support and resistance levels.
For many technicians, MA is an invaluable tool to determine the right entry and exit points in order to execute a profitable trade. However, as elaborated above, MAs are lethal weapons that could help you profit, but at the same time they also have a tendency of giving off a number of False Signals that would hand you a number of grave losses. So, use MAs carefully!
As the saying goes, "In battles, don't use weapons that you don't feel like they are part of your body". Therefore, if you are not familiar with the nature of MAs,
DO NOT base a decision on it, until you 'paper trade' enough to know them
Also, don't forget to use other indicators to complement the entry or exit signals generated by MAs, particulary when determining support or resistance levels. And, don't forget to cut losses when things get worse. Always trade with insurance. If you don't know how to swim, you won't jump into an ocean without wearing a life jacket, will you? :p
Once again, thank you for your attention and have a profitable charting week ahead! :-)
